After calamity, economics leaders rethink strategy

ECONOMICS

Tom Abate, Chronicle Staff Writer

Published
4:00 am PST, Monday, December 20, 2010

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After calamity, economics leaders rethink strategy

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Following the worst financial panic since Herbert Hoover's presidency, the mathematically minded professors who dominate economics face a renewed challenge from their historically inclined peers who think studying the booms and busts of the past offers a better guide to the future than today's predictive algorithms.

Normally a tiff among the tenured set would be little more than academic, but economics is the science that empties pockets or fills purses; its nostrums influence debate over everything from tax cuts to unemployment benefits.

"Free market fundamentalism has been confronted rather violently," Soros lieutenant Robert Johnson told Berkeley graduate students when he visited the campus last month to announce the grant.

"We are rebooting society," added Johnson, who will disburse another $50 million or so to encourage economists to revise their tools and theories. "We have to reinvigorate our social contract and redefine what we mean by civil society."

Gerard Roland, chair of Berkeley's economics department, said the grant comes at a pivotal point in the feud between what academics call conservative or "freshwater" departments such as the one at Chicago and more liberal or "saltwater" schools like his.

"If ever there was a time to rethink our methods, this is it," Roland said.

Top freshwater academic like Robert Lucas, the Nobel Prize-winning economist from the University of Chicago, declined to discuss this professional soul-searching. But fellow traveler Thomas Sargent of New York University pooh-poohed the fresh-salt divide, noting that the math-based approach is widely taught from coast to coast, even in salty Manhattan.

But in a lengthy interview published in September by the Federal Reserve Bank of Minneapolis - the freshwater city where he originally established his economic bona fides - Sargent was asked how all those Ph.D.s, with all their computers and equations, failed to predict the economic tsunami that nearly swamped the global economy.

"It is just wrong to say that this financial crisis caught modern economics by surprise," Sargent said, citing academic economists, some using mathematical models, others observational techniques, who warned of the contagion in advance.

He expected crisis

One economist who unarguably predicted the crisis was former International Monetary Fund researcher Raghuram Rajan. At an August 2005 conclave honoring then-Federal Reserve Chairman Alan Greenspan, Rajan warned that under-regulation had allowed big financial institutions to create and trade mortgage-backed securities, credit default swaps and other complex investments that threatened a nervous breakdown in global finance.

Then vilified, now glorified, Rajan, a professor at Booth Graduate School of Business in Chicago, said freshwater economists are right in saying that warnings were raised, but wrong insofar as their own tenets - backed by the mathematical models favored by academic journals - lulled them into thinking that big financial institutions had the self control not to sell each other a bill of goods.

"It was not so much ideology as it was hubris," Rajan said of conservative economists, Greenspan included, who became so impressed by their own mathematical models as to forget that their algorithms were closer to educated guesses than natural laws.

The reason for this imprecision is simple, economist David Colander of Middlebury College in Vermont told members of the House of Representatives in a September 2009 hearing. Unlike physics, in which atoms consistently follow discernible rules, economic models seek to predict the aggregate outcome of events that depend on individual or institutional behaviors that remain, so far, unpredictable.

"Economics can be thought of as physics with strategic atoms who keep trying to foil any efforts to understand them," Colander said.

Labels too simple

Gregory Rosston, deputy director of the Stanford Institute for Economic Policy Research, said labels like liberal and conservative, or saltwater and freshwater, oversimplify the myriad ways in which scientists are trying to study, improve and ultimately predict the economic behavior of individuals, institutions, industries and nations.

"There's enough blame to go around," Rosston said. "I don't think (recent events are) necessarily a repudiation of the Chicago school of economics as personified by Alan Greenspan, but it definitely shows there is some role for regulation in society."

But if the devil is in the details, then economics remains trapped in a hell in which its top minds can't agree on whether President Obama's stimulus package prevented a second depression, fueled a future inflationary spiral or both.

"There is not a consensus," said Stanford economist John Taylor, who has held policy posts in a Republican administration - in contrast with Berkeley's Christina Romer, the Obama adviser who crafted the stimulus and still believes, along with many saltwater colleagues, that it needed to be larger to jolt the economy into a stronger recovery.

Whether Soros' tiny grant to Berkeley will spark a meeting of minds remains to be seen, although Taylor agreed "there's a huge opportunity to learn from what has happened."

As Romer admitted when she joined Roland and other colleagues in accepting the Soros gift, during her frantic months in the White House, "we were flying largely blind."

Economics has survived ideological upheaval before. The free market economics of Friedman, which had held sway for much of the last 30 years, arose in reaction to several prior decades of interventionist government policies inspired by Depression-era economist John Maynard Keynes.

As the field adjusts the balance between too light and too heavy a government hand, economists will have to hone both their mathematical and historical skills, said UC Berkeley graduate student Issi Romem, who attended the Soros grant award ceremony.

Romem, a 32-year-old Israeli working on his doctorate, said he crossed over to economics from prior studies in architecture and urban planning, which he considered somewhat "artsy."

"I think the math is helpful," he said, while adding that he would hate to see the field "taken to the other extreme, where the insights from historical economists were overlooked."